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Costs of Inflation: Useful notes on the Costs of Inflation

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Costs of Inflation: Useful notes on the Costs of Inflation!

The costs of inflation may be economic or social loss arising from the effects of inflation. Assuming that people hold only non-interest bearing money in the form of currency issued by the government and demand deposits of banks, the costs of inflation refer to the loss in real money balances held by individuals and businesses.

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Since money does not bear a rate of interest, the opportunity cost of holding money rises with the inflation rate which, in turn, reduces the demand for real money balances. Individuals and business enterprises hold cash balances because they yield utility to them. At a higher rate of inflation, they find the purchasing power of the money balances diminishing. In other words, they find that they require more real money balances than before when there is inflation.

The costs of inflation arise when they try to change their existing system of transactions or payments to adjust to a smaller stock of real cash holdings. Individuals or households visit the markets more frequently to buy goods. Business enterprises visit banks more often, increase the frequency of ordering inventories; devote more time and attention in converting money into inventories or financial and real assets.

Thus the change in the transactions or payments patterns of individuals and business enterprises require more time and energy than before. It leads to the diversion of resources from productive to unproductive uses when they are required to visit markets and banks more frequently, maintain excessive inventories of consumer and producer goods, etc.

When the real money balances with the people are reduced due to higher expected rate of inflation, their peace of mind is also disturbed. Thus “the ultimate social cost of anticipated inflation is the wasteful use of resources to economies holdings of currency and other non-interest bearing means of payment.”

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Another social cost of inflation is in terms of the Phillips curve analysis. When inflation starts and is expected to continue, any attempt to reduce its rate of increase- will lead to more unemployment. Increase in unemployment is a loss to the economy in terms of the goods and services which cannot be produced because people available for employment are not used.

The majority of economists also regard the redistributive effects of inflation as the cost of inflation.

The social cost of inflation can be measured in terms of Figure 20. The curve LL1 is the demand curve for real cash balances which can be interpreted as the MP (utility) curve of real cash balances. When the rate of inflation is zero, the real interest rate is equal to the money interest rate at i.

The demand for real cash balances is (M/P). The area under the demand curve LL1 over a given segment of the horizontal axis measures the flow of productivity (utility) from the indicated quantity of real money balances.

When inflation increases at the expected rate of E% (i-r1) the interest rate rises from i to r1 and the demand for real cash balances falls to (M/P). This reduction in real cash balances by (M/P)-(M/P)1 is the social cost of inflation which is measured by the shaded area (M/P)1 PS (M/P).

This area “measures the aggregate loss of productivity (utility) resulting from the destruction of real cash balances which occurs when prices rise initially at the announcement that there will be inflation. The further rise of prices representing the inflation itself is merely sufficient to keep real balances at their new low level and so guarantee that this loss of productivity (utility) will continue as long as the inflation does.”